By Henry Hing Lee Chan

How to Make Financial Innovations Work in China

From
new restrictions on the sale of Universal Life (UL) insurance products by the China
Insurance Regulatory Commission (CIRC), the indefinite suspension of the initial
public offering (IPO) shelf registration system, the stock market circuit
breaker system, the postponement of the new Shanghai stock exchange growth
board by the China Securities Regulatory Commission (CSRC), to the rolling out
of “Draft rules for online lending” and the launch of a national audit on peer
to peer (P2P) lending platforms by the China Banking Regulatory Commission
(CBRC), China’s three financial sector regulators are launching major reviews
of new innovations implemented in the past few years that have been blamed for
the chaos in the financial sector in the second half of last year and early
this year. The extent of remedial measures put up are sober reminders that
these major innovations have failed in their initial forms. Recent stability in
the financial market can be attributed to the restoration of a certain degree
of confidence in the effectiveness of these remedial measures. However, people are
still asking why there were so many missteps and why they were adopted in the
first place.

Aside
from the officially acknowledged reason of coordination failures among the regulators
that provided speculators with policy arbitrage opportunities resulting in the
ultimate market meltdown (Chan, 2016a), the
recently appointed chairman of the CSRC, Liu Shiyu, explained the CSRC policies’
suspension as being due to the absence of complementary measures to make the
original policies work (“China Watchdog
Takes”, 2016). This emphasis on the sequencing of reforms is a new vantage
point to look at the meltdown and offer valuable lessons to understand why the
policies’ missteps were committed.

How Chinese Innovations Differ from Overseas
Cousins

The
UL, IPO shelf registration system, stock market circuit breaker, growth board,
and P2P lending were all ideas that originated from other countries, and while
they were not all successful overseas, they nevertheless did not create that
much market disruptions as in China. Liu’s observation of the poor
complementary policy environment highlighted one of the main issues facing
China.

In
the case of UL, many jurisdictions have not allowed its sale as the product
gives insurance companies too much leeway in directing the investment
destination, creating moral hazard issues. In the case of the US, which
pioneered the product at the turn of the century, strict implementation of the early
policy redemption penalty made the product a real long term life insurance
policy, whereas in China, twisting the term of product redemption essentially
turned the life insurance product into a short term wealth management product
with high indicated promised returns (Chan,
2016b).

In
the case of the stock market circuit breaker, setting the market breaker at 5
percent and 7 percent essentially made hitting the market suspension button
almost a certainty in a market meltdown, as the Chinese market also implements
a 10 percent individual share suspension system. Running the old system plus
the new system just led to a mutual reinforcement of the two systems in price
volatility, and the triggering of the circuit breaker become a fait accompli.
The Chinese stock market increased its volatility in the second half of last
year, and daily suspensions of many stocks under the 10 percent volatility rule
have become commonplace. Introducing such a policy under such a background was
indeed a careless step.

For
the shelf registration system, the anchor premises for its successful
implementation was an effective self-regulating stock exchange and highly
reliable IPO documentation. It is common knowledge in China that both
conditions do not exist at the moment. Stripping the CSRC’s power to approve
IPOs and relying on the stock exchange’s self-governing ability may minimize
bureaucratic inefficiency, but the chance of a bigger fiasco down the road is
very high as the reliability of the stock exchange as a gatekeeper is even
worse than the CSRC’s.

For
the Shanghai growth board, if one checks the records of the Shenzhen growth
board and the subsequent corporate performance of the listed companies, whether
the country needs another growth board under the current setup remains a matter
of public debate.

For the
P2P platform, the mystery remains why the CBRC only published its drafted rules
for online lending in December 28, 2015, after more than 25 percent of P2P
platforms had gone belly up, and the sector had amassed more than RMB 400
billion in assets. P2P appeared as a powerful funding platform in 2013 and the
prolonged regulatory vacuum on P2P platforms remains an unanswered question. In
the face of a still increasing P2P platform default with many closures
attributed to fraught, Chinese regulators have suffered serious reputational
damage. No other country takes P2P platforms as seriously as China and unfortunately,
Chinese savers suffer the most when it boomerangs.

Why Regulatory Failure Happens?

Many
observers attributed the regulatory failure to a combination of factors. First
is that vested interest groups had hijacked the introduction of the innovations
and intentionally left gaps for their policy arbitrations. Second is the
bureaucratic inertia that failed to detect hidden problems with the new
products and reacted only when the situation had reached the boiling point. Third
is the enthusiasm for the innovations which made the regulators focus only on
the positive side of things and forget Murphy’s law. Fourth is the highly
technical nature of financial sector work which causes regulators to always
fall behind the curve, reacting either too little or too late. We are not privy
to the internal discussions of the regulators but it is reasonable to believe
that probably all factors contributed to the failure.

How Regulators Should Proceed

Several
valuable lessons emerged from the recent fiasco.

First,
China’s financial sector is unique. Understanding the unique background of the Chinese
financial sector is important in deciding what are the good policies and
innovations to draw from overseas markets and what should not be touched.
Financial sector decision making is based on available documentation. It is an
information business and vulnerable to information fraud. Many of the dependable
documents available overseas are often absent in China. The fraud committed by the
infamous eZuBao is a classic case: the perpetrator paid almost a billion RMB to
buy cases of corporate fund raising information from corporate insiders and used
it for online applications for project funding. There is no way for big data to
detect such fraud as the information is authentic but is being misused. In a
short period of 18 months, eZuBao duped 900 thousand investors of RMB 50
billion, with 90 percent of cases presented on its platform arranged the
abovementioned way. Chinese investment behavior is also unique; rumours are
common and they drive the market in many instances. Understanding the
psychological aspect of economic decision-making in China is as important as rational
model trajectory, or even more critical in some cases.

Understanding the unique background of the Chinese
financial sector is important in deciding what are the good policies and
innovations to draw from overseas markets and what should not be touched.

Second, China’s current financial
sector is so integrated that regulations must be implemented across sectors
concurrently. There have been many instances of financial sector players
exploiting regulatory time lag between sectors to profit from arbitrage
opportunity, a recent example being the shift of stock margin-financing activities
(场内配资)
from securities firms to banks’ wealth management products (WMP) when CSRC
tightened up in the first half of 2015. This shift happened because CBRC is not
regulating bank’s WMP stock margin financing activities at that time, resulting
in unregulated build-up of WMP margin financing. This was one of the main
reasons behind the irrational surge and subsequent collapse of stock market in
2015.

The coordination issue was noticed
earlier and there were attempts in 2003 and 2008 among People’s Bank of China
(PBoC), CSRC, CBRC, and CIRC to setup informal or formal mechanisms to address
the issue of policy coordination and minimize regulatory arbitrage opportunity
of unscrupulous financial market participants. Unfortunately, both these
efforts failed as the four participating agencies were too keen to protect
their respective regulatory turf. The failure behind the last attempt in 2013
to work out the problem is particularly poignant. The effort was directed by
the State Council and PBoC was the designated leader to work out the
coordination issue. However, even with a higher authority imposing an order of
formal coordination mechanism, the effort still failed. Until a super financial
oversight structure is setup to run synchronized policies in different
financial sectors, perennial regulatory arbitrage issues will make any financial
sector innovations a potential time bomb down the road.

Third,
the decision to proceed with innovation should be based on its chance of
success, and all coordinating policies should be in place before the reforms
proceed. We have noted the difference between Chinese financial innovation and
their overseas cousins. If China believes the innovation is indeed good, it
should not rush the innovation until all complements are in place. A
well-meaning innovation will not automatically deliver success until they are
implemented well on the ground, while slight deviations may blow the innovation
off the ground. Pay attention to details as the devil is always in the details.

Fourth,
entrenched interests are a significant problem in the Chinese financial sector
and care should be exercised when policies are formulated to prevent them from being
hijacked. The spate of arrests of many prominent personalities on insider
trading charges after the crisis, and the revelation of rampant regulatory
arbitrage by insurance players in the past few weeks, point to the extent of
the problems. China has vibrant internet discussion communities and vested
interests have a strong voice in these forums. Public discussion of financial
reforms is often dominated by a single track thinking of liberalization and
anything associated with “innovation” is automatically accorded “right” status.
Either because the thinking is twisted by disappointment over earlier
government failures or planted by vested interests, the public forums on financial
reforms are not very sound at the moment. We can only hope the new emphasis
announced in the last National People’s Congress by the chief prosecutor and
supreme court judge on cracking down financial crimes will mitigate the future
influence of vested interest groups.